If you are comfortable gambling that what happened
yesterday will happen again tomorrow (and you can bear the bruising of
falling down those 18 stairs every few years), then the 70/30 portfolio
is for you. If, however, you choose to believe that you never know what
will happen next, and that you are better off being insulated against
worst-case scenarios, then you might choose the 30/70 approach.
When you play out the real percentages of return
between the two portfolios in the "you never know" projection, the
average return for the 70/30 allocation drops from 10.08% to 6.65%. The
30/70 allocation average drops from 8.08% to 7.38%. Could it be that
over time the market rewards reasonable caution and "measured" optimism
(or what some might call realism)?
One financial planning sage offered, "But maybe they
need the 70/30 returns over time to live the lifestyle they want. How
do you answer that?"
I would answer with these three thoughts:
If you're convinced they need it, make sure they emotionally comprehend what they are committing to before they commit.
If they can't handle manic swings, they might need
to reconsider what they think they'll need and then make adjustments in
spending or lifestyle to compensate.
As the preceding example illustrates, you really
have no guarantee that they'll end up with more money as a result of
the 70/30 over 30/70 allocation. It's all a matter of timing. Retire at
the right time, and you're in luck.
If the industry is going to continue to recommend
80/20 and 70/30 allocations, you'd better pray for the "rose garden"
scenarios to come through-as clients will need the extra income to fund
a 30-year supply of Pepto Bismol!
"Average" Expectations
Perhaps we ought to be more careful how we use the
word "average," because that word sets up an emotional expectation that
real life experience will contradict, thereby sending the emotions into
tilt. Many advisors will tell clients that the S&P has averaged 11%
for the last 20 years. Emotionally that message is often embraced as,
"OK, so we're going to be around 11%, give or take a few points each
year." The reality is that the actual return on the S&P fell within
3% of the mean only four out of those 20 years. The other 16 years, the
returns were either much higher or much lower than the average.
This leads to either much glee or much
panic--neither of which is going to lead to good decisions going
forward. This has been amply demonstrated by mountains of evidence
showing that over that same time frame, the average investor failed to
get the average return. Investors were either driving too fast in their
glee or overriding the brake pedal in their state of panic and
consequently, failed to reap an "average" harvest. The proper emotional
explanation upfront and accompanying allocation would have solved this
problem and the unrealistic expectations that go with it.
We might also do well to do a better job of defining
and illustrating the impact of "standard deviation." The most useful
metaphor I can find for understanding standard deviation is the
market's roller coaster. How steep are the rises and falls? That is
standard deviation. In retirement income planning, standard deviation
becomes a most deviate force.
Lewis Walker, CFP illustrates the impact this way:
"If you had $100,000 and were taking out 8% and the
market declined 10%, you're left with $82,000. The following year you
need a return of 9.769 just to be able to take your 8% and stay at
$82,000 as a base. To take out your 8% and get back to your original
look, you would need a return of 31%." No wonder people's emotions turn
to mush when faced with the realities of standard deviation.
Please Behave
Before anyone starts quoting behavioral finance and
lamenting how stupid clients are constantly buying high and selling
low, allow me to ask, "Who was there to help accommodate and even make
recommendations regarding this stupidity?" It's easy to point the
finger at the whimsical client and to ignore those who "helped" them
leap from the frying pan into the fire.
An advisor recently said to me, "But you don't
understand how hard it was in the late 1990s to tell clients that they
shouldn't be buying these high-risk stocks." My question is, "Why
weren't your clients better educated on the law of gravity?" It's like
I've told my teenagers, "If you're going to fall for the thrill of
driving 100 mph, don't expect to be able to stop when you need to." The
faster you go, the harder you crash, and the more profound the
consequences.
If we help clients get a better understanding of the
emotional aspects of recommended asset allocations and make emotional
comfort one of the primary goals of the selected allocation, we might
end up with much better conversations during the highs and lows.
Today's risk assessment tools don't do the job. If you had asked
clients their risk tolerance in 1999, they would've probably told you
that they were aggressive or moderately aggressive--but that didn't
stop them from running for the exits when the ride got rough. By and
large, many common risk tolerance questionnaires are useless. It's like
asking someone, "In the case of an earthquake, what would you do?" To
which they respond, "Oh, I would help everyone else out first." Sure
you would. Nobody can predict his or her behavior in a panic. A better
way to help people understand the emotional impact of asset allocation
is by using an analogy like the "Stairway to Financial Heaven" so that
they can "feel" the impact of their choice. You can't feel enough with
these risk tolerance profiles to make an honest decision. Go back and
check your clients' answers to those risk profiles, and see for
yourself how many of their answers corresponded with their actions
throughout 2001-2002.
This essay is about emotion. I believe that the
industry has failed to paint the proper emotional context for the
recommendations it has been making to clients regarding asset
allocation.
Now is the time to become emotionally forthcoming
about how rough this ride might feel and what happens when things don't
work out the way they are illustrated on four-color laminated
brochures. All the optimism in the world won't soften the landing of a
bear market or major retraction. Do your best to demonstrate what these
allocations are going to feel like over time (think of it as "market
emotion projections"), and you might possibly see clients choosing the
mirror image of the allocations that have been historically recommended
for them. It may surprise you to know that of the 50-some people I
tested this theory on, almost all of them were financial advisors--and
70% of them were CFPs.
When you frame the choice in emotional instead of
mathematical terms, people are going to make different choices--real
world choices. Nothing is more real than the emotions people feel when
they are losing their hard earned wealth. Mathematical and logical
reasoning leads people toward making conclusions, whereas, emotional
reasoning leads to people making decisions. It's time to present asset
allocation in a manner that makes emotional sense. After all, what fun
is the ride and "getting there" if the experience is filled with nausea?
Mitch Anthony is the author of Your Clients For Life, The New
Retirementality and Your Client's Story and is a regular keynote
speaker at industry events.